12.1 © 2005 Prentice Hall, Inc. Economics for Managers by Paul Farnham Chapter 12: Spending by Individuals, Firms, and Governments on Real Goods and Services

12.2 © 2005 Prentice Hall, Inc. Focus on the Short-Run Potential GDP: maximum amount of output that can be produced Depends on size of labor force, number of structures and amount of equipment in the economy, and state of technology Policy goal is managing aggregate expenditure to keep economy close to potential output without starting inflation Managers tend to focus on short-run

12.3 © 2005 Prentice Hall, Inc. Real Versus Nominal Terms Real terms: measuring expenditures and income with price level held constant Nominal terms: measuring expenditures and income with price level allowed to vary

12.4 © 2005 Prentice Hall, Inc. Components of Aggregate Expenditure Aggregate expenditure: sum of personal consumption, investment, government, and net export expenditures on total amount of real output produced Personal consumption expenditure: sum of durable goods, nondurable goods, and services

12.5 © 2005 Prentice Hall, Inc. Personal Consumption Expenditure and Income Keynesian consumption function: assumes that as disposable income increases, consumption spending increases by smaller amount Marginal propensity to consume (MPC) Marginal propensity to save (MPS) Saving: amount of disposable income households do not spend on consumption

12.6 © 2005 Prentice Hall, Inc. Level of Personal Taxes Level of taxes affects consumption spending Economic Growth and Tax Relief Act of 2001 Tax cut of 2003 Taxes can be cut or increased temporarily or permanently

12.7 © 2005 Prentice Hall, Inc. Real Interest Rate Changes in interest rate affect spending, especially in durables Real interest rate Nominal interest rate Lenders charge borrowers nominal rate (i) based on the real rate (r) and the expected rate of inflation

12.8 © 2005 Prentice Hall, Inc. Consumer Confidence University of Michigans Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI) Some debate as to whether these confidence indices predict changes in consumer spending

12.9 © 2005 Prentice Hall, Inc. Consumer Credit and Level of Debt Federal Reserve Board monitors use of consumer credit Increased consumer credit may have restraining influence on consumption Consumption function: C = f (Y, T p, r, CC, W, CR, D) C = C 0 + c 1 Y

12.10 © 2005 Prentice Hall, Inc. Consumption Function Autonomous consumption expenditures: determined by factors other than level of real income in the economy Induced consumption expenditures: result from changes in level of real income in the economy

12.11 © 2005 Prentice Hall, Inc. Components of Aggregate Expenditure Figure 12.5a and 12.5b Consumption Y C C2C2 C1C1 0 Y1Y1 Y2Y2 C0C0 Y C Y I I2I2 I1I1 0 Y1Y1 Y2Y2 I0I0 Y I Investment

12.12 © 2005 Prentice Hall, Inc. Government Y G 0 G0G0 Components of Aggregate Expenditure Exports Y X 0 X0X0 Figure 12.5c and 12.5d

12.13 © 2005 Prentice Hall, Inc. Components of Aggregate Expenditure Figure 12.5e Y M M2M2 M1M1 0 Y1Y1 Y2Y2 M0M0 Y M Imports Consumption, investment, and import spending are assumed to be a function of the level of real income. Government and export spending are determined by factors other than the level of real income. Consumption, investment, and import spending are assumed to be a function of the level of real income. Government and export spending are determined by factors other than the level of real income.

12.14 © 2005 Prentice Hall, Inc. Gross Private Domestic Investment GPDI: total amount of spending on nonresidential structures, equipment, software, residential structures, and business inventories in a given time Variety of factors influence GPDI

12.15 © 2005 Prentice Hall, Inc. Factors Influencing GPDI Business investment spending and real income Real interest rate Business taxes Relative prices: cost of capital versus cost of other inputs Expected profits and business confidence

12.16 © 2005 Prentice Hall, Inc. Factors Influencing GPDI Capacity utilization Rates are prepared monthly by Fed for manufacturing, mining, and electric/gas utilities industries Residential investment spending Inventory investment Inventory investment function: I = f (Y, r, T B, PR, CU)

12.17 © 2005 Prentice Hall, Inc. Government Expenditure Includes total amount of spending by federal, state, and local governments on consumption outlays, depreciation, and investment capital outlays Determined by legislative and executive institutions of all levels of government

12.18 © 2005 Prentice Hall, Inc. Government Expenditure Fiscal policy: use of expenditure and taxation policy to pursue macroeconomic goals of high employment and low inflation G = f (Y, Policy) G = G 0 Both equations assume spending is determined only by policy and not by real income in economy

12.19 © 2005 Prentice Hall, Inc. Government Expenditure Net export expenditure: difference between export spending on domestically produced goods and services by individuals in other countries and import spending on foreign produced goods and services by domestic residents X = F (Y, Y*, R)

12.20 © 2005 Prentice Hall, Inc. Government Expenditure Currency exchange rate: rate at which one nations currency can be exchanged for another (is determined in foreign exchange markets) Import expenditures M = f (Y, R) M = M 0 + m 1 Y

12.21 © 2005 Prentice Hall, Inc. Aggregate Expenditure and Equilibrium Aggregate expenditure (E): planned spending on currently produced goods and services by all sectors of the economy E = C + I + G + X – M Aggregate expenditure function: relationship between aggregate expenditure and income, all other variables constant E = f (Y, T P, r, CC, W, CR, D, T B, PR, CU G, Y*, R)

12.22 © 2005 Prentice Hall, Inc. Aggregate Expenditure Function Y E 0 E0E0 Slope = (c 1 + i 1 – m 1 ) E 0 represents autonomous aggregate expenditure determined by factors other than real income

12.23 © 2005 Prentice Hall, Inc. Equilibrium Level of Income and Output Level of income where desired spending equals value of aggregate output and income received from that production Injections: supplement to consumer spending that increases domestic aggregate output and income Leakages: uses of current income for purposes other than purchasing currently produced domestic goods and services

12.24 © 2005 Prentice Hall, Inc. Adjustment Toward Equilibrium Y EE 0 YEYE E0E0 E1 E1 45 o A Slope = c 1 (assuming i 1 = m 1 = 0) Only at this level of income and output is desired expenditure just equal to value of output produced and income generated.

12.25 © 2005 Prentice Hall, Inc. Adjustment Toward Equilibrium At income level Y e1, individuals want to purchase more goods and services than are currently produced Firms then have to draw down on their existing inventories of goods (called unplanned inventory decrease)

12.26 © 2005 Prentice Hall, Inc. Changes in Equilibrium F A Figure Y E E2 0 Y E1 Y E2 E E1 E0E0 E1E1 E1E1 E o B C E Y

12.27 © 2005 Prentice Hall, Inc. The Multiplier Multiplier: change in income and output resulting from a change in autonomous expenditure Multiplier effect: results from fact that increase in autonomous expenditure represents an injection of new spending in circular flow of economic activity End result is multiple increase in income determined by size of MPC and the term [ 1 / (1 – MPC)]

12.28 © 2005 Prentice Hall, Inc. Investment-Saving (IS) Curve Shows alternative combinations of real interest rate and real income Theoretical construct focusing on relationship between interest rate and level of real income and output Summarizes the relationship between real interest rate and real spending

12.29 © 2005 Prentice Hall, Inc. Interest-Related Expenditure Function Shows planned consumption and investment spending as a function of real interest rate Points downward showing an inverse relationship between interest rate and planned consumption and investment expenditure

12.30 © 2005 Prentice Hall, Inc. IRE Function Summarized Figure IS D A Y r 0 Y1Y1 Y2Y2 r2r2 r1r1 B C

12.31 © 2005 Prentice Hall, Inc. Shifting the IS Curve Changes in any factor influencing autonomous aggregate expenditure causes IS curve to shift IS: Y = f (r, T P, CC, W, CR, D, T B, PR, CU, G, Y*, R)

12.32 © 2005 Prentice Hall, Inc. Summary of Key Terms Aggregate expenditure function Autonomous consumption expenditures Capacity utilization rates CCI and CSI Consumption function Currency exchange rate Equilibrium level of income and output Fiscal policy and government expenditure

12.33 © 2005 Prentice Hall, Inc. Summary of Key Terms Gross private domestic investment Induced consumption expenditures Injections IRE function and IS curve Investment spending function Leakages Marginal propensity to consume and to save (MPC) and (MPS) Multiplier

12.34 © 2005 Prentice Hall, Inc. Summary of Key Terms Net export expenditure Nominal interest rate and real interest rate Personal consumption expenditure Potential GDP Real terms and relative prices Saving Unplanned inventory increase and unplanned inventory decrease

12.35 © 2005 Prentice Hall, Inc. Do you have any questions? Do you have any questions?